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Creating a Production Information
System for the MWD by Paul J. Updike INTRODUCTION The purpose of this article is to provide
insight into how a production table for a real-world manufacturer is created.
Typical economic textbooks define specialized economic jargon in an uncommon
manner, sometimes not the same way that actual production facilities such as
a typical manufacturing firm might use those words. I believe the reason for
this is that few small to mid-sized firms have full-time economists on staff.
Another reason economists miss the boat is that most manufacturing firms are
grappling with real situations that are not resolved with
mathematically-congruent, elegant curves. There is the textbook approach to
production, with formulas and curves and models, but there also is an
approach that works in the real world, where people expect to earn real
profit. That certainly does not mean a typical economics’ textbook approach
to creating production tables is bad or wrong, just less than helpful. In this lecture, I will discuss
and explain the production/manufacturing problems faced by Microwave
Materials Division (MWD), a division of Rogers Corporation, and one solution
that did not work and my solution that did. I will show how people, pricing
structure, cost structure, revenue, accurate reporting of production
activity, and high-technology machinery combined to solve a significant
manufacturing issue. I will also demonstrate how well the problem was solved.
This article includes a
simplified, though somewhat technical description of how the MWD production
actually works, providing an alternative to a typically, economically-sound,
technical description of production that one might find in a textbook. I will
also provide a definition list of important terms that may differ from the
definitions commonly given by economists to similar terms. Sound economic
reasoning requires using these terms in an economically rational way.
Finally, I will describe the success achieved. DIFFERENCE OF OPINION Typical economists and I do not
see eye to eye on the subjects of production and cost analysis. The reasons
may be three-fold: ● There exists
more economically-able accountants than accounting-able economists. I do not
blame economists for not wanting to learn double-entry bookkeeping skills –
most reasonable people do not desire to, even though accountants learn them
anyway. ● Many economists received
their formal education when accounting depended on using historical costs for
computational purposes and typical cost accountants counted instead of measuring
to calculate costs. ● Activity-based costing
(ABC) has been around for maybe 25 years, quite likely after many textbook
writers learned about the silliness that economically-challenged cost
accountants, using historical cost exclusively, might create for firms. DEFINITIONS OF TERMS I have not encountered many people
in production firms who use the terms marginal revenue, marginal costs,
marginal product and marginal productivity, though the typical economists’
assertions regarding these four terms are reasonably argued and the
conclusions logical. However, the concepts of marginal product and marginal
revenue are understood at the gut
level by successful owners of most small and medium-size manufacturing firms. ● Fixed costs – are those
costs, relating to operating the firm, which are relatively constant over the
contemplated production run, and over the planning horizon. Generally, fixed
costs are not directly related to production, nor are they easily relate-able
to production. Often, fixed costs are period-related costs. ● Variable Costs – are those
costs that vary directly with production and are more easily measured and
more obviously related to the process of production than fixed costs. ● Direct Costs – There are
two major kinds of direct costs, direct labor and direct material. Most
economists call these two costs, inputs. ● Direct labor costs (DL)
are input costs for people who directly handle and/or manipulate the direct
material (DM) as the material is transformed into something else through the
magic of manufacturing. ● Direct material costs
(DM), such as raw material, are the costs to the firm to use that direct
material as an input to their production run. ● Indirect Costs – can be
labor, material, or overhead costs that are essential to the production
process, but not easily measured and/or discretely reported. ● Department Costs – are one
logical way to allocate overhead costs and indirect costs to the production
process. Activity-based costing provides another, often better way to
attribute costs to production units. ● Throughput Units – The
number of units that pass through the production process in a specified
period. ● Yield Loss – The
unfinished production units that are scrapped at different points along the
production process, with varying amounts of material and value-added
discarded. ● Finished goods are the output
units that the entire production process is designed to produce. Finished
goods are usually the throughput units that made it through the entire
production process unscathed. (Those ‘good’ output units are those that are
not damaged, scrapped, reworked, etc.) Each good finished output unit carries
as its cost/value, a portion of the total costs. That is, total production
costs for a specific period is divided by the total good output unit which
equals cost per good unit. ● Overhead Costs (OH) – A
category of costs including either essential fixed costs or variable costs,
though they may not be directly related or easily related to production.
Overhead costs may also include some or all of the indirect costs. A
significant benefit of using activity-based costing is increasing the
traceability and source of production costs, which dramatically reduces the
size of the overhead cost bucket. ● Added Value – The net
labor value added to the direct material measured at various stages of
production. ● Cost – The amount of
dollars incurred by the seller
while producing a specific good. ● Price – The amount of
dollars paid by the buyer to
the seller for purchasing a specific produced good. NOTE – Some of these terms may be
overlapping in their meaning and application. One set of simplified equations
that will demonstrate the relationship of some of these terms is as follows: DL + DM + OH = Total Manufacturing
Costs. Total Manufacturing Costs + Fixed
Costs = Total Cost Total Cost / Good Output Units =
Cost per Unit Price per Unit – Cost per Unit =
profit or (loss) ACTIVITY-BASED COSTING Douglas T. Hicks has created and
installed over 100 ABC costing systems. The author of the readable book “Activity-Based
Costing, Making It Work for Small and Mid-Sized Firms,” Hicks points out that
Activity-based costing (ABC) works effectively when three requirements are
met: 1) the business must start with
costs that are defined and measured properly; 2) costs, activities, and products
or services must be connected by true cause; and 3) the
resulting cost information must be used in appropriate way. (Hicks, preface) This citation from Hicks' book
is included to demonstrate that ABC is not an accounting/computational
wonderland, but that ABC works in the real world, when and if ABC is
installed and used in an economically-reasonable manner. The production
information system created for MWD was NOT exactly an activity-based costing
solution, but close. MWD PROBLEM DEFINITION In a nutshell, The Microwave
Division’s (MWD) manufacturing problem was the lack of accurate and relevant
manufacturing cost information. The MWD sold thousands of different
compositions of widths, lengths, and thicknesses of finished material to
customers such as Raytheon, General Dynamics, and Texas Instruments for use
by them in their government defense business. As typical economists might point
out, the endless combinations of production shapes and sizes could be in the
millions, or more, when taken to an extreme. So the first thing done was to
limit the range only to that which was finite and relevant. By limiting the
solution to one-inch increments, we made the universe of possibilities small
enough to wrap our arms around it. The previous MWD costing approach,
which did not work well, was to assume all manufacturing-caused differences
away, instead, simply calculating how much material in square inches was in the cut-size piece being
sold, adding a significant markup and thereby determining a minimum price
that was hoped to cover related costs. In costing, we call that the
‘peanut-butter approach’, using broad averages to uniformly apply costs. We can illustrate the dangers of using
‘peanut-butter costing’ by looking at the San
Francisco Giants baseball team. EXAMPLE OF DANGER OF USING AVERAGES Everyone loves to watch batters
hit home runs. It is exciting. In fact if you watch the highlight films on
ESPN, you get to see a replay of almost every home run hit that day in the
Major Leagues. How many home runs might the San Francisco Giants hit in a
season? 130? 150? 180? Let us assume 150. Each major league team has 25
players on its active roster. There are 10 pitchers, leaving 15 batters. Sure
a pitcher may hit a home run, but
you would rather a pitcher pitch a
shutout. Therefore, 15 Giant batters hit
150 home runs a year or 10 home runs each, on average. Because Barry Bonds
was once a San Francisco Giant batter, you could count on him to hit an
average of 10 home runs a year. My question is, is that why the Giants paid
Barry Bonds $18 million a year? In 2001, Barry Bonds hit 73 home runs, almost
half the total home runs hit by the entire This ‘peanut butter costing’
approach for MWD included adding up all the firm’s costs expected to be
incurred within a year, excluding material inputs, then allocating a portion
of the total cost to each cut-size being sold. (Material cost was also
calculated and added to the total cost.) What this ‘peanut butter’ approach
did not allow is finished material unit cost differentiation caused by
production process variation. Peter Drucker suggests (see
Drucker article on Measuring nearby) that the price for a good is determined
by the market for that good. Instead of determining what the costs are and
adding a markup to the cost of manufactured goods to come up with a price,
Drucker says one needs to make sure the manufactured cost of the good is less
than the price the market will allow for that good, ensuring a profit. If
not, stop the production process. Drucker also says we need to measure, not
count, to determine accurate costs. MWD PRODUCTION PROCESS At the MWD, ten separate 48-inch
long sheets of material of various thickness and composition were laid on top
of each other, then pressed together in the same
window of a special 40-ton press, at 700 plus degrees in order to produce
material that had the desired dielectric properties. The press was high
technology machinery that compresses and bakes product using eight
separate windows curing eight different combinations of 10 @ 48-inch sheets
at a certain temperature and pressure. Achieving the desired dialectic
properties required stacking together certain raw materials, with
certain weights and certain characteristics, then baking the sheets at a
certain temperature and pressure for a certain length of time within a window
of the press. The outside cladding of the output
unit (typically called a finished good in manufacturing) included a certain
thickness of metal on the outside, either aluminum or copper with unsmooth
surfaces, then a certain thickness of what was called ‘paper’ stacked inside
the cladding metal. The ‘paper’ was actually a paper-like slippery chemical
compound called PTFE (polytetrafluoroethylene,
known as ‘Teflon™’, to most people.) RESULT OF USING MY COSTING METHODOLOGY The MWD production process lacked
a methodology that allowed a reasonable measurement of the cost of each of
the various production operations required to produce different finished good
units. MWD was not interested in employing a cost system that required too
much effort or was too costly to maintain. Nor did the production process at
MWD lend itself to Direct Labor (DL) reporting, which is what 2/3 of the
manufacturing world used in the 1980s to measure costs. Besides, most of the
added value (value added) to the MWD output units occurred due to the
activity of salaried people like chemists, managing the complex temperature
and pressure of the production process on the individual sheets, not from
hourly factory workers efforts. I designed and implemented a cost
information system that scrupulously measured the cost of each of more than
6,000 different products, not including different size cuts. The year that
ended before my costing methodology was installed saw total revenue of
approximately $5 Million and Net Operating Profit (NOP) of close to $500,000
or 10% NOP at the MWD. Those results are not bad for any manufacturing firm,
all things considered. The first year that my new costing system was used,
total revenue rose to $7 Million and the NOP profit increased to over 20%. After using my cost information
system for five years, the annual sales at the MWD grew to $20 Million. Even
better, the NOP margin rocketed to 35%. The reason for this incredible leap
in NOP is instructive. Because the new cost system approximated reality and
generated accurate and usable cost information, the sales people were able to
adjust the price of the products up or down according to what the market
would allow without hurting sales. In fact, with this accurate cost
information, the MWD sales people knew the individual product costs and could
price the product accordingly. Result? In some cases,
manufacturing margins on certain output units reached 70%. Rogers Corporation
netted incredible profits. References: Colander,
D.C. (2001). Microeconomics (4th
ed.). [ Douglas T. Hicks, Activity Based Costing, Making It Work
for Small and Mid-Sized Firms, John Wiley & Sons, Inc., Peter F. Drucker, We Need To Measure, Not Count,
Wall Street Journal, April 13, 1993. Paul J. Updike, Standard Product Costing System
Proposal for the Rogers Corporation; |
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